MODULE 21

FISCAL POLICYAND THE

MULTIPLIER

Expansionary fiscal policy shifts the AD curve to the right, and contractionary fiscal policy shifts the AD curve to the left.

However, just knowing the direction of the shift is not enough, policy makers need estimates of how much the AD curve is shifted by a given policy.

In order to get these estimates, the policy makers use the concept of the multiplier.

USING THE MULTIPLIER TO ESTIMATE THE INFLUENCE OF

GOVERNMENT POLICY

The government’s purchases of goods and services starts a chain reaction throughout the economy.

This increase in disposable income will lead to a rise in consumer spending, which induces firms to increase output, leading to a further rise in disposable income, which will lead to another round of consumer spending increases, and so on…

MULTIPLIER EFFECTS OF AN INCREASE IN GOVERNMENT

SPENDING

Government Spending

Firms Earn Revenues

Households receive income (wages, profit, interest, and

rent

This effect is due to the multiplier: the ratio of the change in real GDP caused by an autonomous change in aggregate spending to the size of that autonomous spending.

Therefore, any change in government spending will lead to an even greater change in real GDP.

The initial change in spending, multiplied by the multiplier, will give us the final change in real GDP.

A reduction in government spending will have the same effect, but with a negative sign, reducing real GDP more than the initial change in spending.

MULTIPLIER EFFECTS OF AN INCREASE IN GOVERNMENT

SPENDING

Expansionary or contractionary fiscal policy is not only undertaken by changing government spending.

Governments can also change transfer payments or taxes.

However, a change in government transfers or taxes shifts the AD curve by less than an equal-size change in government purchases, which results in a smaller effect on real GDP.

In the case of transfer payments, households will only spend a part of the additional income received (the MPC) and save part (the MPS).

MULTIPLIER EFFECTS OF CHANGES IN GOVERNMENT TRANSFERS AND

TAXES

EFFECT ON REAL GDP

FIRST ROUND

SECOND ROUND

THIRD ROUND

…

EVENTUAL EFFECT

$50 BILLION RISE IN GOVERNMENT PURCHASES OF

GOODS AND SERVICES

$50 BILLION

$25 BILLION

$12.5 BILLLION…

$100 BILLION

$50 BILLION RISE IN GOVERNMENT

TRANSFER PAYMENTS

$25 BILLION

$12.5 BILLION

$6.25 BILLION

…

$50 BILLION

HYPOTHETICAL EFFECTS OF A FISCAL POLICY WITH A MULTIPLIER

OF 2

Overall, when expansionary fiscal polity takes the form of a rise in transfer payments, real GDP may rise by either more or less than the initial government outlay (the multiplier may be either more or less than 1).

If a smaller share of the initial transfer has been spent, the multiplier on that transfer would be less than 1; if a larger share of that initial transfer is spent, the multiplier would be more than 1.

MULTIPLIER EFFECTS OF CHANGES IN GOVERNMENT TRANSFERS

A tax cut has an effect similar to the effect of a transfer: it increases disposable income, leading to a series of increases in consumer spending.

However, the overall effect is smaller than that of an equal-size increase in government spending.

This autonomous increase in aggregate spending is smaller because households save part of the amount of a tax cut (the MPS).

MULTIPLIER EFFECTS OF CHANGES IN GOVERNMENT TAXES

Taxes introduce a further complication: they typically change the size of the multiplier.

In the real world, government rarely impose a lump-sum tax (in which the amount of a tax a household owes is independent of its income).

Instead, tax revenue is raised via taxes that depend positively on the level of real GDP, which reduce the size of the multiplier.

MULTIPLIER EFFECTS OF CHANGES IN GOVERNMENT TAXES

Economists argue that it also matters who gets the tax cuts or increases in government transfers.

A dollar spent on unemployment benefits increases AD more than a dollar’s worth of dividend tax cuts, as people with lower incomes tend to spend a higher share of any increase in disposable income and wealthier people tend to save more of any increase in disposable income.

MULTIPLIER EFFECTS OF CHANGES IN GOVERNMENT TAXES

Government taxes capture some part of the increase in real GDP that occurs in each round of the multiplier process, since most government taxes depend positively on real GDP.

Therefore, disposable income increases by considerable less than $1 once taxes are included in the model.

The increase in government tax revenue when GDP rises is not a deliberate action of the government; it is a consequence of the way tax laws are written.

Sources of government revenue increase automatically when real GDP increases.

HOW TAXES AFFECT THE MULTIPLIER

Income tax receipts increase when real GDP rises because the amount each individual owes in taxes depends positively on income, and households’ income rises when real GDP rises.

Sales tax receipts increase when real GDP rises because consumption increases and people buy more goods and services.

Corporate profit tax receipts increase when real GDP rises because profits increase when the economy expands.

TAXES AS AUTOMATIC STABILIZERS

The effect of these automatic increases in revenue is to reduce the size of the multiplier.

Since the government takes away some of the increase in real GDP (in the form of taxes) at each successive round of spending, the increase in consumer spending is smaller than it would be if taxes weren’t part of the process.

The result of this is to reduce the multiplier.

TAXES AS AUTOMATIC STABILIZERS

The same mechanism that causes tax revenue to increase when real GDP rises causes it to fall when the economy contracts, so the effects of the negative demand shocks are smaller than they would be if there were no taxes.

The decrease in tax revenue reduces the negative effect of the initial fall in AD.

This automatic decrease in government tax revenue caused by a fall in real GDP (caused by a decrease in the amount of taxes households pay) acts like an automatic expansionary fiscal policy: a decrease in taxes.

TAXES AS AUTOMATIC STABILIZERS

The automatic increase in government tax revenue caused by a rise in real GDP (caused by an increase in the amount of taxes households pay) acts like an automatic contractionary fiscal policy: an increase in taxes.

Government spending and taxation rules that cause fiscal policy to be automatically expansionary when the economy contracts and automatically contractionary when the economy expands, without requiring any deliberate action by policy makers, are called automatic stabilizers.

TAXES AS AUTOMATIC STABILIZERS

These rules that govern tax collection are not the only automatic stabilizers, but they are the most important ones.

Transfer payments tend to rise when the economy is contracting and fall when the economy is expanding.

Like changes in tax revenue, automatic changes in transfers tend to reduce the size of the multiplier because the total change in disposable income that results from a given rise or fall in real GDP is smaller.

OTHER AUTOMATIC STABILIZERS

Discretionary fiscal policy is fiscal polity that is the direct result of deliberate actions by policy makers, rather than automatic adjustments

Generally, due to time lag problems, economist tend to support the use of discretionary fiscal policy only in special circumstances.

The size of automatic stability depends on responsiveness of changes in taxes to changes in GDP: The more progressive the tax system, the greater the economy’s built in stability

Automatic stability reduces instability, but does not correct economic instability.

DISCRETIONARY FISCAL POLICY

GDP (Billions) Consumption (Billions)

$100 $120

200 200

300 280

400 360

500 440

600 520

700 600

EXERCISE: COPY THIS TABLE

EXERCISE (CONT.)

a) Graph this consumption schedule, and determine the size of the MPC.

b) Assume a lump sum (regressive) tax of $10 billion is imposed at all levels of GDP. Calculate the tax rate at each level of GDP. Graph the resulting consumption schedule, and compare the MPC and the multiplier with those of the pre-tax consumption schedule.

c) Now suppose a proportional tax with a 10 percent tax rate is imposed instead of the regressive tax. Calculate and graph the new consumption schedule and note the MPC and the multiplier

EXERCISE (CONT.)

d) Finally, impose a progressive tax such that the tax rate is 0% when GDP is $100, 5% at $200, 10% at $300, 15% at $400, and so forth. Determine and graph the new consumption schedule, noting the effect of this tax system on the MPC and the multiplier.

e) Explain why proportional and progressive taxes contribute to greater economic stability, while a regressive tax does not. Demonstrate using a graph.

EXERCISE PART a)

a) The MPC = = = .8

The marginal propensity to consume is .8.

EXERCISE PART b)

GDP,billions

Tax, billions

DI, billions

Consumption after tax

Tax rate, percent billions

$100 $10 $90 $112 10%

200 10 190 192 5.0

300 10 290 272 3.3

400 10 390 352 2.5

500 10 490 432 2.0

600 10 590 512 1.7

700 10 690 592 1.4The MPC is still .8 = = , just as it was before the tax increase.The multiplier is still 5 = =

EXERCISE PART c)

GDP,billions

Tax, percent

DI, billions

Consumption after tax

$100 10% $90 $112

200 10 180 184

300 10 270 256

400 10 360 328

500 10 450 400

600 10 540 472

700 10 630 544

• The MPC is .72 = = • The multiplier is now 3.57 = = .

EXERCISE PART d)

GDP,billions

Tax, billions

DI, billions

Consumption after

tax

Tax rate, percent

MPC

$100 $0 $100 $120 0% undefined

200 10 190 192 5 0.72

300 30 270 256 10 0.64

400 60 340 312 15 0.56

500 100 400 360 20 0.48

600 150 450 400 25 0.40

700 210 490 432 30 0.32• The MPC decreases, so the multiplier changes.• Proportional and (especially) progressive tax

systems reduce the size of MPC and therefore, the size of the multiplier.

• A lump sum tax does not change the MPC or the multiplier.